What is financial risk?
Financial risk can be defined as the potential for losing capital by stakeholders. Financial risk can affect the ability of the government to manage its financial policies and observe its debt obligations. The financial risk can impact corporations that experience debt or engage in ventures that require financial costs. Credit risk, liquidity risk, and operational risk are some common financial risks. However, there are different methods and tools available that can measure, manage, and lower financial risk.
An Overview of Financial Risk: Types, Causes, and Management
Financial risk means the chance of losing money due to various factors that affect the performance and stability of financial markets, sectors, or entities. Financial risk is not only a concern for markets or companies but also for governments, individuals, and small businesses. Financial risk can have significant effects on the income, wealth, and well-being of individuals and businesses. Financial risk can be divided into four categories: Market, liquidity, credit, and operational risk.
Market Risk: Market risk can be defined as the risk of losing wealth due the changes in market prices and rates. For example, investors might face market risk while evaluating their stocks, bonds, or commodities fluctuates due to supply and demand, economic conditions, or geopolitical influences.
Credit Risk: Credit risk is the risk of insolvency or non-payment by borrowers or counterparties. For example, Banks or financial institutions may face credit risk when they loan money to individuals or businesses, and they may not be able to repay their loans. Lenders may also experience more expenses while collecting debts.
Liquidity Risk: Liquidity risk is the risk of not being capable to sell or buy an asset quickly enough to control or underrate a loss. For example, if traders require funds and want to sell their assets on the market, and they cannot find buyers or sellers for their assets at a fair market price or in a required time. Liquidity risk can also affect the ability of borrowers or lenders to meet their short-term obligations, such as paying bills or rolling over debt.
Operational Risk: Operational risk refers to the possibility of suffering a loss because of human mistakes, system breakdowns, fraud, or external events. For instance, operational risk can arise when businesses have ineffective management or faulty financial reasoning or when they face interruptions, accidents, or natural disasters. Operational risk can also impact the performance and quality of the processes, systems, and controls that support the entity’s operations. Operational risk can be affected by factors such as the entity’s culture, governance, and strategy, as well as the abilities, knowledge, and behavior of the staff and stakeholders.
Various methods and tools are available that can be used to measure, manage, and reduce financial risk, such as risk analysis, diversification, hedging, and insurance